Liang Hongfu

Goldman Sachs case rolls dice on disclosure

By Hong Liang (China Daily)
Updated: 2010-04-24 06:48

The securities fraud case against Goldman Sachs in the United States involving certain mortgage bonds has once again cast a spotlight on financial derivatives.

Critics charge that these products of synthetic collateralized debt obligation (CDO) serve no real purpose in the financial markets. Trading in derivatives is similar to rolling the dice, some say.

Others contend that synthetic CDO was just a kind of financial derivative that could help facilitate the flow of capital by allowing a wider spread of risks among mortgage lenders, investors and speculators.

Indeed, such arguments can apply to almost all derivative products, including the more common varieties such as index futures. At issue in the Goldman case is not the product itself but the way it was being sold to what Goldman described as "knowledgeable" investors, including banks in the US and Europe.

The crucial question is whether it's wrong for Goldman to have failed to tell investors that the hedge fund manager they were betting against was involved in picking the bundles of mortgage loans they were betting on. The decision of the court can help further clarify the definition of material information whose importance has been greatly magnified in the aftermath of the subprime mortgage credit crisis.

In the early-1990s when the derivative wave began to hit the shores of the Hong Kong financial market, private banks were keen on designing specially structured derivative products to help their clients generate income from their assets, which were, at that time, mainly shares of stocks. The concept of these products was similar to that behind the instruments that have been brought into question in the Goldman case. Both parties are betting on the price movements of the underlying assets they may or may not own.

Private bank clients welcomed these derivative products at the time when the outlook of the stock market was clouded by uncertainties. These products were tailor-made to help them obtain some income from their shareholdings other than the meager dividends they had already made on those investments.

Of course, such a scheme worked only when there were other investors in the market willing to take the bet. Those who did really didn't care whom they were betting against.

One of the first stories I did for a regional magazine in Hong Kong in the early 1990s was about the proliferation of financial derivatives. Bankers I interviewed then told me that despite their perplexity, financial derivatives would play an increasingly important role in facilitating the flow of capital in the markets from investors to borrowers.

The outbreak of the subprime mortgage credit crisis in the US has shown that the regulatory mechanisms in the financial capitals of the world have fallen behind the development of derivatives. Of major concern to regulators is the level of disclosure in the sales of derivative products.

In Hong Kong, for example, the government has set much stricter requirements for banks to inform their clients of the risks in the investment products offered for sale. But there will always be contention as to what constitute "material" information. We hope that the pending Goldman case will shed some new light on the issue.

jamesleung@chinadaily.com.cn

(China Daily 04/24/2010 page9)